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Use the following information for questions 8 to 11
Use the following information for questions 8 to 11. Caracal Ltd. is comparing different capital
structures. The management of the company needs to compare the WACC of the different financing
options at its disposal. Specifically, there is a need to compare the WACC's of the two options it is
considering. The first option, is to borrow funds while the second option is to raise equity. The company
has a target D/E ratio of 0.45 which it intends to revert to as soon as possible, while its current D/E ratio
is 0.50. Currently, the company has a beta of 1.5. The tax rate is 28%, the risk free rate 7% and the
market risk premium, 6%. A very similar company recently issued bonds with a YTM of 10%. The
company has R15 000 in total assets, R5000 in total liabilities with a book cost of 5% and has R10 000 in
equity. The company currently has EBIT of R1000 which it expects to stay the same for the foreseeable
future. R5000 will be raised, either by debt or equity. If debt is raised, the company expects to issue
bonds at a market related YTM with a coupon rate of 10%. What would its WACC under the equity
option be?
Expert Solution
D/E = 0.45
Weight of debt (wd) = D/(D+E)
= 0.45/(1 + 0.45)
= 0.45/1.45
= 31.03%
Cost of equity by (CAPM):
Ke = Rf + Beta x (Rm - Rf)
here,
Rf = Risk-free rate = 7%
Market Risk Premium = 6%
Beta = 1.5
Ke = 7% + 1.5 x 6% = 7% + 9%
= 16%
Cost of debt (Kd) = 10%
Tax rate = 28%
WACC = wd x Kd x (1 - tax%) + D/E x Ke
= 31.03% x 10% x (1 - 28%) + 45% x 16%
= 2.23% + 7.2%
= 9.43%
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